“Davidson” has been offering commentary here regarding the “Natural Rate” for ~5years now. He was the first to introduce me to the concept in detail and his analysis based on it has been nothing short of spectacular. Given Yellen and the Fed’s incessant waffling on interest rate increases, I have to say I’m inclined to go with his commentary here. Wicksell was NOT interested in ST rates. Read him here:
He submits:
Yellen’s thinking of ‘Natural Rate’ is simply wrong. Wicksell’s concept of the ‘Natural Rate’ was not about short term rates. It was about the long term growth rate of an economy with current inflation as I use it. He expressly says the ‘Natural Rate’ is that over several economic cycles. He did not have the economic measures that we have today.
Yellen and Bernanke act as if the ‘Natural Rate’ is the Fed Funds Rate which shows the Fed thinking misperceives the concept. The ‘Natural Rate’ is something Volker and Greenspan followed if one tracks what they did. What they did was to track T-Bill rates and adjust after-the-fact the Fed Funds Rate to be higher. Volcker kept Fed Funds ~1.0% higher while Greenspan gradually reduced Fed Funds to be about 40bps higher. The 10yr Treasury was allowed to find its own level.
When T-Bill rates gradually rose with economic/investment activity to equal the 10yr Treas rate, the credit spread becoming zero caused bank lending to stall which produced a recession. Yellen’s Fed has kept 10yr Treas rates below 2% thinking this would stimulate mtg lending. It has not because banks with the current regulatory environment cannot make loans to any but the most credit worthy. Avg FICO score for mtg loans is reported to be ~750 today when we should be seeing avg loans in the 650-700 range.
The Fed does not understand the concept of the ‘Natural Rate’.
From the WSJ:
Fed Decision Makers Wrestle With So-Called Natural Rate
Disagreement about long-term outlook leads to the writings of a long-dead Swedish expert
Updated June 12, 2016 1:10 p.m. ET
While Federal Reserve officials debate when to next raise short-term interest rates, they also are wrestling with the question of how high to lift them in coming years.
Signs point toward the new normal being much lower than in the past, which has broad implications for when the Fed should tighten monetary policy, how quickly, and how far.
Fed officials disagree about their likely end point, in part because they are struggling to understand why another underlying interest rate—the mysterious natural rate—has fallen in recent years. And for that many are turning to the musings of Knut Wicksell, a Swedish expert on the subject who died 90 years ago.
According to the textbooks, this so-called natural rate is the inflation-adjusted rate that’s consistent with the economy operating at its full potential, expanding without overheating. Also known as the equilibrium or neutral rate, it balances savings and investment.
The natural rate can’t be observed directly; the Fed knows it has been reached only by how the economy responds. “It’s like discovering Pluto: you can only see the effect of the gravitational pull,” said Eddy Elfenbein, an investor and blogger at the site Crossing Wall Street, comparing it to the dwarf planet whose existence was inferred from the orbits of Uranus and Neptune.
This matters in part because the natural rate guides how the Fed sets its benchmark fed-funds rate, which influences other borrowing costs throughout the economy. If the Fed pushes rates too high, it could undermine investment and cause a recession. If it holds rates too low, demand could grow too quickly, producing inflation or financial bubbles.
“The practical implication is when a Fed person talks about the natural rate of interest, what they’re telling you is what they think is the terminal rate of the next hiking cycle,” said Adam Posen, president of the Peterson Institute for International Economics and a former member of the Bank of England’s monetary policy committee.
Most economists figured the natural rate was around 2% just before the financial crisis. Today, seven years after the recession, most estimates are around or just below zero.
“We’re seeing no pickup, none whatsoever, in the natural rate even as the economy has gotten back to full strength,” John Williams, the San Francisco Fed president who has spent years studying it, said in a recent interview with The Wall Street Journal.
This implies the central bank won’t be moving its benchmark federal-funds rate up much from its current level between 0.25% and 0.50% over the next few years. This, in turn, means lower rates for borrowers and lower returns to savers.
Policy makers are likely to leave their benchmark rate unchanged Wednesday at the conclusion of their two-day policy meeting, and could consider moving in July or September if the economy improves. They also will release Wednesday new projections for where they think the rate will rest in the long term.
The Fed’s estimate of its long-run fed-funds rate has been falling. In March, when officials released their most recent estimates, the median was 3.3%. Adjusted for their expectation of 2% inflation, that suggests a natural rate of 1.3%, down from 1.75% in June last year.
One risk for the Fed and the economy is that a low natural rate leaves less room for the central bank to cut rates if it wants to spur faster growth during a recession or boost inflation to meet its 2% target.
MORE at link above…..